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Subprime lending

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Subprime lending, also called "B-Paper," "near-prime," or "second chance" lending, is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history. A subprime loan is one that is offered at a rate higher than A-paper loans due to the increased risk. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others.

Subprime lending is typically defined by the status of borrowers. A subprime loan is, by definition, a loan made to someone who could not qualify for a more favorable rate. Subprime borrowers typically have low credit scores and histories of payment delinquencies, charge-offs, or bankruptcies. Because subprime borrowers are considered at higher risk to default, subprime loans typically have less favorable terms than their traditional counterparts. These terms may include higher interest rates, regular fees, or an up-front charge.

Proponents of the subprime lending in the United States have championed the role it plays in extending credit to consumers who would otherwise not have access to the credit market. [1] But opponents have criticized the subprime lending industry for predatory practices such as targeting borrowers who did not have the resources to meet the terms of their loans over the long term. These criticisms have increased since 2006 in response to the growing crisis in the U.S. subprime mortgage industry, wherein hundreds of thousands of borrowers have been forced to default, and several major subprime lenders have filed for bankruptcy.

History

Subprime lending evolved with the realization of a demand in the marketplace and businesses providing a supply to meet it. With bankruptcies and consumer proposals being widely accessible, a constantly fluctuating economic environment, and consumer debt load on the rise, traditional lenders are more cautious and have been turning away a record number of potential customers.[citation needed] Statistically, approximately 25% of the population falls into this category (credit score < 620).[citation needed]

Definition of subprime lending

While there is no official credit profile that describes a subprime borrower, most have a credit score below 660. [2],

Subprime lenders

To access this increasing market, lenders take on the risks associated with lending to people with poor credit ratings. Subprime loans are considered to carry greater risk for the lender due to earlier mentioned credit risk characteristics of the typical Subprime borrower. Lenders use a variety of methods to offset these risks. In the case of many Subprime loans, this risk is offset with a higher interest rate. In the case of Subprime credit cards, a Subprime customer may be charged higher late fees, higher over limit fees, yearly fees, or up front fees for the card. In the case of Subprime credit cards, in contrast to Prime credit cards, customers generally are not given a "grace period" to pay late. These late fees are then charged to the account, which frequently drive the customer over their limit, resulting in over limit fees. Thus the fees compound, resulting in higher returns for the lenders.

Subprime borrowers

Subprime offers the opportunity for borrowers with less than ideal credit to gain access to credit. Borrowers use this credit to purchase homes, or in the case of a cash out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, remodeling a home, or even paying down a high interest credit card. However, due to the risk profile of the subprime borrower, this access to credit comes at the price of higher interest rates.

Generally, subprime borrowers will display a range of credit risk characteristics that may include one or more of the following:

  • Two or more loan payments paid past 30 days due in the last 12 months, or one or more loan payments paid past 60 days due the last 24 months;
  • Judgment, foreclosure, repossession, or non-payment of a loan in the prior 24 months;
  • Bankruptcy in the last 5 years;
  • Relatively high default probability as evidenced by, for example, a credit bureau risk score (FICO) of 660 or below (depending on the product/collateral), or other bureau or proprietary scores with an equivalent default probability likelihood; and/or

Types of subprime lending

Subprime mortgages

As with subprime lending in general, subprime mortgages are often defined by the type of consumer to which they are made available. According U.S. Department of Treasury guidelines issued in 2001, "Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories."

Subprime mortgage loans are riskier loans in that they are made to borrowers unable to qualify under traditional, more stringent criteria due to a limited or blemished credit history. Subprime borrowers are generally defined as individuals with limited income or having FICO credit scores below 620 on a scale that ranges from 300 to 850. Subprime mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender.

Although most home loans do not fall into this category, subprime mortgages proliferated in the early part of the 21st Century. About 21 percent of all mort­gage originations from 2004 through 2006 were subprime, up from 9 percent from 1996 through 2004, says John Lonski, chief economist for Moody's In­vestors Service. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market.

There are many different kinds of subprime mortgages, including:

  • interest-only mortgages, which allow borrowers to pay only interest for a period of time (typically 5-10 years);
  • “pick a payment” loans, for which borrowers choose their monthly payment (full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan);
  • and initial fixed rate mortgages that quickly convert to variable rates.

This last class of mortgages has grown particularly popular among subprime lenders since the 1990s. Common lending vehicles within this group include the "2-28" loan, which offers a low initial interest rate that stays fixed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. The new interest rate is typically set at some margin over an index, for example, 5% over a 12-month LIBOR. Variations on the "2-28" loan concept include the "3-27" and the "5-25".

Subprime credit cards

Beginning in the 1990s, credit card companies in the United States began offering subprime credit cards to borrowers with low credit scores and a history of defaults or bankruptcy. These cards often begin with low credit limits and usually carry extremely high fees and interest rates as high as 30% or more.[3] In 2002, as economic growth in the United States slowed, the default rates for subprime credit card holders increased dramatically, and many subprime credit card issuers were forced to scale back or cease operations.[4]


Proponents of subprime lending

Individuals who have experienced severe financial troubles are often labeled as higher risk and therefore cannot obtain conventional financing. These individuals may have had job loss, previous debt or marital problems, or unexpected medical issues. Often, these events were unforseen and cause a major setback in finances. As a result, late payments, charge-offs, repossessions and even foreclosures may result.

Due to these previous credit problems, these individuals may be precluded from obtaining any type of loan for an automobile. To meet this demand, lenders have seen that a tiered pricing arrangement, one which allows these individuals to pay a higher interest rate, may allow loans which otherwise may not occur.

From a servicing standpoint, these loans have higher collection defaults and experience higher repossessions and charge offs. Lenders use the higher interest rate to offset these anticipated higher costs.

Provided a consumer will enter into this arrangement with the understanding that they are higher risk, and must make diligent efforts to pay, these loans do indeed serve those who would otherwise be underserved. The consumer must purchase an automobile which is well within their means, and carries a payment well within their budget.

Criticisms of subprime lending

U.S. subprime mortgage crisis

Main article: subprime meltdown

Beginning in late 2006, the U.S. subprime mortgage industry entered what many observers have begun to refer to as a meltdown. A steep rise in the rate of subprime mortgage foreclosures has caused more than two dozen subprime mortgage lenders to fail or file for bankruptcy, most prominently New Century Financial Corporation, previously the nation's second biggest subprime lender.[5] The failure of these companies has caused stock prices in the $6.5 trillion mortgage bundled securities market to collapse, threatening broader impacts on the U.S. housing market and economy as a whole. The crisis is ongoing and has received considerable attention from the U.S. media and from lawmakers in the early part of 2007. [6][7]

Observers of the meltdown have cast blame widely. Some have highlighted the predatory practices of subprime lenders and the lack of effective government oversight.[8] Others have charged mortgage brokers with steering borrowers to unaffordable loans, appraisers with inflating housing values, and Wall Street investors with backing subprime mortgage securities without verifying the strength of the underlying loans. Borrowers have also been criticized for entering into loan agreements they could not meet. [9] Many accounts of the crisis also highlight the role of falling home prices since 2005. As housing prices rose from 2000 to 2005, borrowers having difficulty meeting their payments were still building equity, thus making it easier for them to refinance or sell their homes. But as home prices have weakened in many parts of the country, these strategies have become less available to subprime borrowers.[10]

Several industry experts have suggested that the crisis may soon worsen. Lou Ranieri of Salomon Brothers, considered the inventor of the mortgage backed securities market in the 1970s, warned of the future impact of mortgage defaults: "This is the leading edge of the storm. … If you think this is bad, imagine what it's going to be like in the middle of the crisis." [11] Echoing these concerns, consumer rights attorney Irv Ackelsberg predicted in testimony to the U.S. Senate Banking Committee that five million foreclosures may occur over the next several years as interest rates on subprime mortgages issued in 2004 and 2005 reset from the initial, lower, fixed rate to the higher, floating adjustable rate or "Adjustable rate mortgage". [12] Other experts have raised concerns that the crisis may spread to the so-called Alternative-A (Alt-A) mortgage sector, which makes loans to borrowers with better credit than subprime borrowers at not quite prime rates.[13]

Some economists, including former Federal Reserve Board chairman Alan Greenspan, have expressed concerns that the subprime mortgage crisis will impact the housing industry and even the entire U.S. economy. In such a scenario, anticipated defaults on subprime mortgages and tighter lending standards could combine to drive down home values, making homeowners feel less wealthy and thus contributing to a gradual decline in spending that weakens the economy. [14] Other economists, such as Edward Leamer, an economist with the UCLA Anderson Forecast, doubts home prices will fall dramatically because most owners won't have to sell, but still predicts home values will remain flat or slightly depressed for the next three or four years.[15]

As the crisis has unfolded and predictions about it strengthening have increased, some Democratic lawmakers, such as Senators Charles Schumer,Robert Menendez, and Sherrod Brown have suggested that the U.S. government should offer funding to help troubled borrowers avoid losing their homes.[16] Some economists criticize the proposed bailout, saying it could have the effect of causing more defaults or encouraging more risk lending.

See also

Notes

  1. ^ Goolsbee, Austan. "'Irresponsible' Mortgages Have Opened Doors to Many of the Excluded." The New York Times, March 29, 2007.
  2. ^ Subprime mortgages
  3. ^ "Need a Loan? No Problem."
  4. ^ http://www.cardweb.com/cardtrak/pastissues/aug02.html
  5. ^ Morgenson, Gretchen. http://select.nytimes.com/search/restricted/article?res=F00914FE3B550C728DDDAA0894DF404482 News Analysis: Crisis Looms in Mortgages". The New York Times, March 11, 2007. Retrieved April 19, 2007.
  6. ^ http://biz.yahoo.com/ap/070312/mortgage_meltdown_q_a.html?.v=1
  7. ^ http://www.ml-implode.com/
  8. ^ "Opening Statement of Chairman Chris Dodd - Hearing on Mortgage Market Turmoil: Causes and Consequences"
  9. ^ [1]
  10. ^ Morgenson, Gretchen. "FAIR GAME; Home Loans: A Nightmare Grows Darker". The New York Times, April 8, 2007. Retrieved on April 19, 2007.
  11. ^ "Has the Housing Crisis Finally Arrived?" The Trumpet.com, March 29, 2007. Retrieved on April 19, 2007.
  12. ^ http://money.cnn.com/2007/03/22/real_estate/subprime_lenders_deny_responsibility/index.htm?postversion=2007032218
  13. ^ Fleckenstein, Bill. "Next: The real estate market freeze". MSN.com, March 12, 2007. Retrieved on April 19, 2007.
  14. ^ Strasburg, Jenny. "Subprime Defaults to Soar, Hurt Lenders, Funds Say". Bloomberg.com, March 15, 2007. Retrieved on April 19, 2007.
  15. ^ Associated Press. "Will subprime mess ripple through economy". MSN.com, March 13, 2007. Retrieved on April 19, 2007.
  16. ^ Zibel, Alan and Dan Caterinicchia (04-11-2007). ""U.S. Housing Aid needed, Schumer says"". Retrieved 04-19-2007. {{cite web}}: Check date values in: |accessdate= and |date= (help); Unknown parameter |Publisher= ignored (|publisher= suggested) (help)
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